What is a Synthetic Long Stock Position?

Today you will learn about a basic synthetic option position called the synthetic long stock position.

You can
create a synthetic long stock position to replicate and replace buying stock
outright. You also can create a synthetic short stock position to replicate and
replace selling stock outright.

A synthetic
long stock position is created when you purchase one at-the-money call option
and sell one at-the-money put option at the same strike price and same expiration
cycle. The position represents buying
100 shares of the underlying.

If you would
like to create a larger position, the call and put options must be at a one to
one ratio.

Both the synthetic
long stock and the synthetic short stock strategy have the potential to reduce margin requirements for you.

A synthetic
long stock position can be entered as a debit or a credit. Whether or not you pay a debit or receive a
credit to enter the position can depend upon where the price of the underlying
is trading in relationship to the option strike price you are using to create
the position.

A Risk Graph is helpful to visualize
the similarities between traditional long stock and synthetic long stock…

A Risk Graph
shows many important items. One of those items is how the movement of the price
of the underlying will affect the underlying’s value.

To
understand the relationship between a traditional long stock position and a
synthetic long stock position, let’s take a look at a risk graph showing each
position.

Here’s a risk graph of AAPL traditional long stock…

Figure A: 100 shares AAPL Traditional Long Stock

This risk
graph is showing the price of AAPL is currently 193.90. Let’s assume you purchased the stock at the
current price 193.90.

If the
underlying price increases, it will be indicated on the diagonal red line. If
the underlying stock stays above the 193.90 the stock position will show a
profit.

If the
underlying moves down below the 193.90 entry price, the long stock position
will show a loss. This loss will be
indicated on the red diagonal line.

You must
include your commission costs to determine your actual profit or loss.

Here’s an example of a synthetic long
position…

Figure B: AAPL
Risk Graph Synthetic Long Stock Position

This is a
risk graph showing an AAPL synthetic long stock position. This position was created
by purchasing an at-the-money 21 DEC 18 195 long call option and selling an
at-the-money 21 DEC 18 195 put option.

As you can
see, both options have the same strike price and the same expiration cycle.

Please
notice the diagonal line which indicates the profit and loss of the stock.

Do you see
how the synthetic long option position has a similar risk profile when compared
to the 100 shares of AAPL risk graph in Figure A?

How is a Synthetic Long Stock Option
position constructed?

At the same
time at the same strike price and the same expiration date;

Buy 1 at-the-money (ATM) Call option

Sell 1 at-the-money (ATM) Put option

How to calculate the profit of a
synthetic long stock position is shown below:

There is
unlimited profit potential up to the expiration date of the options.

If the position is entered as a
debit:

Profit = Underlying Price
minus Strike Price of the Long Call minus the net debit you paid if the trade
was entered as a debit minus commissions.

One of the
key differences between buying stock outright and creating a synthetic stock
position is: an option has an expiration date of which you must be aware. It will expire. Stock does not have an expiration date.

If you own
stock that pays dividends, you receive those dividends. If you create a synthetic position, you will
not receive dividends. Options do not
pay dividends.

In the
United States, stock which you hold for a certain period of time may have tax
advantages. A synthetic option position
does not receive those same tax advantages.

Simulate buying or selling indexes
using a synthetic long stock position.

Indexes such
as RUT and SPX do not allow you to purchase the underlying outright.

You can
create a synthetic position using options, which would be identical to buying
or selling the underlying.

If you want
to create a long position to simulate buying the index, you would buy an
at-the-money call option and sell the at-the-money put option using the same
strike price and same expiration.

If you want
to create a short position which would simulate selling the index, you would buy
the at-the-money put option and sell the at-the-money call option using the
same strike price and same expiration.

Key Takeaways

The synthetic long stock strategy is
a bullish position.

To create the position, purchase a
call option and sell a put option at the same strike price in the same
expiration cycle.